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Avoiding a New American Recession

The US may be headed for a recession in 2013, even if the country avoids going over the “fiscal cliff.” But a gradual phase-in of an overall cap on tax expenditures, combined with reform of entitlement spending, could achieve the long-run fiscal consolidation that America needs without risking a new recession.

CAMBRIDGE – The United States may be headed for a recession in 2013. Even if the country avoids going over the “fiscal cliff,” a poorly designed political compromise that cuts the deficit too quickly could push an already weak economy into recession. But a gradual phase-in of an overall cap on tax deductions and exclusions (so-called tax expenditures), combined with reform of entitlement spending, could achieve the long-run fiscal consolidation that America needs without risking a new recession.

The US economy has been limping along with a growth rate of less than 2% during the past year, with similarly dim prospects in 2013, even without the shock of the fiscal cliff.  That is much too weak a pace of expansion to tolerate the fiscal cliff’s increase in tax rates and spending cuts, which would reduce demand by a total of $600 billion – about 4% of GDP – next year, and by larger sums in subsequent years.

President Barack Obama’s proposed alternative to the fiscal cliff would substantially increase tax rates and limit tax deductions for the top 2% of earners, who now pay more than 45% of total federal personal-income taxes. His budget would also increase taxes on corporations, and would end the current payroll-tax “holiday,” imposing an additional 2% tax on all wage earners.

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